Unit 2: Aggregate Demand and Supply and Fiscal Policy 1
Apr 01, 2015
Unit 2:Aggregate Demand and Supply and Fiscal Policy
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Topic 1: Aggregate Demand
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Aggregate Demand is all the goods and services that buyers are willing and able to purchase at different
price levels.
Aggregate means “added all together.”
The Demand for everything by everyone in the US.
What is Aggregate Demand?
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Aggregate Demand Curve
Price Level
Real domestic output (GDPR)4
AD is the demand by consumers, businesses, government, and
foreign countries
AD
There is an inverse relationship between
price level and Real GDP.
Shifters of Aggregate Demand
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Shifts in Aggregate Demand
Price Level
Real domestic output (GDPR)
AD
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** General rule: An increase in spending shifts AD right, and decrease in spending shifts it left
AD1
AD2
Shifters of Aggregate Demand1. Change in Consumer Spending
Consumer Wealth (Boom in the stock market…)Consumer Expectations (People fear a recession…)Household Indebtedness (More consumer debt…)Income Taxes (Decrease in income taxes…)
Wealth= assets that generate money (real estate, stock, property)
* Important note: A change in WAGES does NOT impact C in AD because a change in nominal wages does mean a change in REAL wages (purchasing power)
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Shifters of Aggregate Demand
2. Change in Investment Spending business puts $ back into the business
Interest Rates (Price of borrowing $)Future Business Expectations (High expectations…)Business Taxes (Higher corporate taxes means…)Capital stock, construction and inventory
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Shifters of Aggregate Demand3. Change in Government Spending
(infrastructure…)(Nationalized Heath Care…)(defense spending…)
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4. Change in Net Exports (foreign income)
AD = GDP = C + I + G + Xn
Topic 2: The Multiplier Effect
Why do cities want the Superbowl in their stadium?
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MULTIPLIER EFFECT
• Someone’s spending (whether it be consumer, business, government etc) will always become someone else’s income
• The person who receives the income will turn around and spend it and the cycle continues
• Because of this there is a multiplied impact of spending on the economy.
Marginal Propensity to ConsumeMarginal Propensity to Consume (MPC)•How much people consume rather than save when there is a change in income.
MPC= Change in Consumption Change in Income
Examples: 1. If you received $100 and spent $50.2. If you received $100 and spent $80.3. If you received $100 and spent $90.
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Marginal Propensity to Save
MPS= Change in Saving Change in Income
Marginal Propensity to Save (MPS)•How much people save rather than consume when there is a change in income.
Examples: 1. If you received $100 and save $50. MPS? 2. If you received $100 and save $30. MPS?
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Why is this true?Because people can either save or consume
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MPC + MPS = 1
How is Spending “Multiplied”?Assume the MPC is .5 for everyone
•Assume the Super Bowl comes to town and there is an increase of $100 in Ashley’s restaurant.
•Ashley now has $100 more income.
•She saves $50 and spends $50 at Carl’s Salon
•Carl now has $50 more income
•He saves $25 and spends $25 at Dan’s fruit stand•Dan now has $25 more income.
This continues until every penny is spent or saved15
How multiplier effect works
• New income of $100 ; MPC = .5 * remember someone’s spending becomes
someone else’s income
Round Income Spending Savings
1 $100 $50 $50
2 $50 $25 $25
3 $25 $12.50 $12.50
Spending multiplier
» If an increase in spending = more $ goes into the economy (total GDP will increase)
1/MPS
» If a decrease in spending = less $ goes into the economy(total GDP will decrease)
- 1/MPS
Practice
• 1. If MPC is .8, what is the spending multiplier if investment spending decreases???
• 2. If the MPS is .1, what is the spending multiplier if government spending increases???
The smaller the MPS, the greater the spending multiplier will be!!!
How to use the spending multiplier
If Consumer Spending increases by $3 million, and the MPC is .8 How much will the GDP change by?
spending multiplier X change in spending
How figured: 1. find spending multiplier
1/MPS = 1/.2 = 5
2. Multiply the spending multiplier by the change in spending: 3 X 5 = $15
GDP will increase by a total of $15 million (5 X 15)
Tax Multiplier
• looks at the impact of taxes on the entire economy
If taxes go down: If taxes go down, people have more $ to spend MPC/MPS (if decrease in taxes)
If taxes go up: If taxes go up, people have less money to spend
- MPC/MPS (if increase in taxes)
Practice
• MPC is .9, and taxes go up, what is the TAX multiplier???
• MPS is .2, and taxes go down, what is the TAX MULTIPLIER???
How to use the tax mutiplier• If the government decreases taxes by $50 million, and the
MPC is .8 by how much will the GDP change by? Tax multiplier X change in TAXES
How figured: 1. Find Tax multiplier
.8/.2 = 4
2. Multiple tax multiplier by change in taxes 4X50 = $200
GDP will increase by $200 million
Balanced Budge Multiplier
• Spending multiplier will always have a bigger impact on the economy than tax multiplier if spending and taxes both change by the same amount!
Balanced Budget Multiplier
• The G attempts to balance the budget by changing taxes and spending at the same time
• The spending multiplier and the tax multiplier combine to from the BALANCED BUDGET MULTIPLIER
BALANCED BUDGET MULTIPLIER = 1 1 X change = impact on the economy
How to use the balanced budget multiplier
• In order to balance the budget, the G increases spending by $20 million while at the same time raising taxes by $20 million.
$20 X 1 = $20 • GDP will INCREASE by: $20 million
Topic 3: Aggregate Supply
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What is Aggregate Supply?Aggregate Supply is the amount of goods and
services that firms will produce in an economy at different price levels.
The supply for everything by all firms.
Aggregate Supply differentiates between short run and long-run and has two different curves.
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Short Run Aggregate Supply Curve
Price Level
Real domestic output (GDPR)
AS
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AS is the production of all the firms in
the economy
Shifters of SR Aggregate Supply
Shifts in SR Aggregate Supply
Price Level
Real domestic output (GDPR)
AS
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An increase or decrease in national production can shift the curve right or left
AS1
AS2
Shifters of SR Aggregate Supply
1. Change in Resources Prices and quantity of Domestic and ImportedResources
Nominal wages
Supply Shocks(Negative Supply shock…)(Positive Supply shock…)
Shifters of SR Aggregate Supply
2. Legalities * Business taxes (shifts AD too!)
Subsides Government Regulations
3. Change in Productivity
4. Change in Technology 32
Adam Smith1723-1790
John Maynard Keynes1883-1946 33
Topic 4: Classical
vs. Keynesian
view of SRAS
CLASSICAL THEORY
• 1. AS is VERTICAL (at FE) • 2. WAGES are FLEXIBLE (both upward and
downward) AND ADJUST QUICKLY TO PRICE CHANGES
• 3. Economy can self adjust• 4. No G intervention in economy is necessary
Debates Over Aggregate SupplyClassical Theory – AS is vertical
Price level
Real domestic output, GDP
AS
Qf35
Debates Over Aggregate SupplyClassical Theory Due to wages being flexible, a change in AD will not change
quantity, only price level
Price level
Real domestic output, GDP
AS
Qf
AD
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Keynesian Theory
1. AS is horizontal at low output
2. Wages are STICKY – they do NOT quickly adjust to price changes
3. G intervention is necessary to return economy to FE
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Keynesian Theory- Horizontal ASRecession will be persistent because wages are not
flexible (they will not go down to return the economy to FE)
Price level
Real domestic output, GDP
AS
Q38
Q
Debates Over Aggregate Supply
Keynesian TheoryA change in AD effects output only not inflation
Price level
Real domestic output, GDP
AS
Qf
AD2
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AD1
Q1
Three Ranges of Aggregate Supply1. Keynesian Range- Horizontal at low output2. Intermediate Range- Upward sloping3. Classical Range- Vertical at FE
Price level
Real domestic output, GDP
AS
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Keynesian Range
IntermediateRange
ClassicalRange
Topic 5: LONG RUN Aggregate Supply
In the Short Run, wages haven’t had the time to adjust to price changes
Example: • If a firm currently makes 100 units that are sold for $1
each. The only cost is $80 of labor. How much is profit?
Profit = $100 - $80 = $20What happens in the SHORT-RUN if price level doubles?
• Now 100 units sell for $2, TR=$200. How much is profit? Wages haven’t had the time to
adapt to the change in prices Profit = $120
With higher profits, the firm has the incentive to increase production.
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Long-Run Aggregate SupplyIn the Long Run, wages do have time to adjust
to price changesSame Example:
• The firm has TR of $100 and uses $80 of labor. Profit = $20.
What happens in the LONG-RUN if price level doubles?• TR still =$200 (100 x $2)• BUT…In the LONG RUN workers demand higher wages
to match prices. Wages have had the time to adjust to price changes - So labor costs double to $160
Profit = $40, but REAL profit is unchanged.If REAL profit doesn’t change
the firm has no incentive to increase output. 42
Long run Aggregate Supply
Price level
GDPR
In Long Run: Q at FE on LRAS; price level can be any level
LRAS
Long-runAggregate
Supply
QY
Full-Employment(Trend Line)
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Shifts of LRAS
Shifters of LRAS
LRAS similar to PPC!!!
1. Change in technology 2. Change in QUANTITY of resources
* General rule: LRAS will never shift by itself (SRAS will shift with it) However, SRAS can shift without LRAS shifting
Practice
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Which curve will shift??? AD, SRAS, LRAS
• 1. An increase in consumer confidence • 2. An increase in incomes of U.S. trading partners • 3. A large decrease in the price of imported oil which
impacts the resource cost of business • 4. An increase in business taxes • 5. An improvement in technology• 6. 25% stock market increase over a two month period
which increases household wealth • 7. a decrease in interest rates • 8. A increase in wages
Topic 6: Putting AD and AS together to getEquilibrium Price Level and Output
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Topic 7: Economic Stability
• A stable economy is represented by: 1. Economic growth 2. Price stability 3. Full employment
Economic Instability
• Recession
• High unemployment
• Inflation
• Stagflation
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Unemployment Inflation GDP Growth
Good less than 6% 1%-4% 2.5%-5%
Worry 6.5%-8% 5%-8% 1%-2%
Bad 8.5 % or more 9% or more .5% or less
Inflationary and Recessionary Gaps
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Full employment equilibriumEconomy at FE with acceptable price level
Price Level
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AS
Inflationary Gap
GDPR
LRAS
QY
AD1
PL1
Q1
Output is high and employment is greater than FE
Actual GDP above
FE/potential GDP
Price Level
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AD
GDPRQY
PL1
Q1
LRAS AS1
Recessionary Gap
Output low and employment is less than FE
Actual GDP below
FE/potential GDP
STAGFLATION
• if both inflation and unemployment are high STAGFLATION will occur
• What curve shift illustrates this problem? This problem is represented by a DECREASE in SRAS
The economy begins at FE and the G increases spending. Shift the curve on the
graph
What economic problem does this cause???
The economy begins at FE and net export spending decreases.
Shift the curve on the graph
What economic problem does this cause???
Topic 8: Short Run and Long Run
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Price Level
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AD
AS
Shifts in AD or AS change the price level and output in the SR, but only price level in the
LR
GDPRQY
PLe
LRAS
Price Level
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AD
AS
Example: Assume inflation is occurring in the economy
GDPR
LRAS
QY
AD1
PL1
Q1
Price Level
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AS
Now, what will happen in the LONG RUN?
GDPRQY
AD
PL1
Q1
LRAS
Inflation means workers seek higher wages and wages increase (shifts AS to LEFT)
AS1
PL2
Back to full employment with higher price level
Price Level
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AD
AS
GDPR
LRAS
QY
ADAD1
Q1
PL1
Example: Assume a recession is occurring in the economy
Price Level
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AS
What happens in the Long Run? Due to recession, workers accept lower wages. As WAGES go down, SRAS shifts to
the right
GDPR
LRAS
QY
AD
PL1
Q1
AS1
PL2
AS increases as workers accept lower wages and production
costs fall
The Ratchet EffectA ratchet (socket wrench)
permits one to crank a tool forward but not backward.
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Does deflation (falling prices) often occur?Not as often as inflation. Why?
Prices and wages are more flexible upward as opposed to downward
Like a ratchet, prices can easily move up but not down!
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Topic 9: The Phillips Curve
SRPC Shows tradeoff between inflation and unemployment.
Inflation
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SRPC
Short Run Phillips Curve
Unemployment2% 9%
1%
5%
When the economy is overheating, there is low unemployment but high inflation (A)
When there is a recession, unemployment is high but
inflation is low (B)
A
B
Shifts of Short run Phillip’s curve
1. inflation and unemployment move in the SAME direction, there will be a SHIFT of the SRPC
-If inflation and unemployment both go up; SRPC shifts to the RIGHT
- If both go down, SRPC shifts to the LEFT 2. Change in inflationary expectations
if these increase, SRPC shifts RIGHT if these decrease, SRPC shifts LEFT
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Assume stagflation occurs Draw an AD/AS graph showing this
SRAS SHIFTS TO THE LEFT
In the Short run, what happens Price level? increasesUnemployment? increases
Inflation
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SRPC
Unemployment
What is impact on SRPC? Shifts to the right
SRPC1
Consumers begin to save more money. Draw an AD/AS graph that shows this
AD SHIFTS TO THE LEFT
In the short run, what happens to Price level? DecreasesUnemployment? INcreases
Inflation
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A
B
SRPC
Unemployment
What is impact on SRPC? Movement down along original curve
The prices of resources decrease.Draw an AD/AS graph showing this
SRAS SHFITS TO THE RIGHT What happens in the short run to
price level? decreases unemployment? decreases
Inflation
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SRPC 1
Unemployment
What is impact on SRPC? Shifts to the left
SRPC
From Short run Phillips curve to Long run Phillips curve
• Because the SRPC is continually shifting in the LONG RUN, there is no trade off between inflation and unemployment
Example: The economy is at FE and interest rates increase
What problem does this create? RECESSION
What happens in the long run to…– Price level DECREASES– Unemployment DECREASES
What will happen to the SRPC in the Long Run?SHIFTS to the LEFT
Example: The economy is at FE and consumer spending increases
What problem does this create? INFLATION
What happens in the long run to…– Price level? INCREASES – Unemployment INCREASESWhat will happen to the SRPC in the Long Run?
SHIFTS TO the RIGHT
Inflation
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1%
5%
3%
5%
LRPC
In the long run there is no tradeoff between inflation and unemployment due to SRPC continually shifting
The LRPC is vertical at the Natural Rate of Unemployment
SHIFTS OF LRPC
LRPC can shift if there is a change in the Natural rate of unemployment
• LRPC will never shift by itself (if you shift LRPC, shift SRPC too!)
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Phillips curve at FE equilibrium
Inflation
SRPC
UnemploymentUY
LRPCThe unemployment rate is at the NATURAL RATE
and
inflation rate is at the EXPECTED RATE
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Inflationary Gap on Phillips Curve
Inflation
SRPC
UnemploymentUY
LRPC
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Recessionary Gap on the Phillips Curve
Inflation
SRPC
UnemploymentUY
LRPC
Topic 10: Fiscal Policy
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Fiscal Policy- Based on Keynesian theory
Fiscal Policy: Actions by Congress to speed up or slow down the economy
A stable economy should have: 1. stable prices 2. full employment
3. economic growth
Two Types of Fiscal Policy
1. Discretionary Fiscal Policy-• Congress creates and passes a new bill
ex. Congress votes to implement a tax cut
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Two Types of Fiscal Policy
2. Automatic Stabilizers Permanent spending or taxation laws enacted to work
counter cyclically to stabilize the economy Ex: Welfare, Unemployment, Min. Wage, etc.
•When there is high unemployment, unemployment benefits to citizens increase consumer spending.
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Expansionary Fiscal Policy
• Implemented during RECESSION
• Goal is to SPEED UP economy without causing too much inflation
• Need to increase AD
Video example of expansionary fiscal policy
How can the government speed up the economy????
1. Increase government spending (public works, roads, schools etc.) *need to account for the SPENDING MULTIPLIER
2. Decrease personal income taxes (Consumers will have more $, so they will spend
more) *need to account for the TAX MULTIPLIER
• * government can increase its spending, decrease taxes or do both – any of these actions increase AD
• Expansionary policy will result in a DEFICIT BUDGET
• Deficit Budget: the government spends more $ than what they take in
Contractionary Fiscal Policy
Implemented during INFLATION
Goal is to SLOW DOWN economy without causing recession
Want to decrease AD
How can the government slow down the economy???
1. Decrease government spending * need to account for spending multiplier
2. Raise personal income taxes *need to consider tax multiplier
• * Government can decrease its spending, raise income taxes or both – any of these actions will slow down the economy/decrease AD
• Contractionary Policy results in a SURPLUS BUDGET
• Surplus Budget: the government spends less $ than what they take in
Problems With Fiscal Policy
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Problems With Fiscal Policy
1. Deficit Spending!!!!•A Budget Deficit – government spending exceeds its revenue. •The National Debt is the accumulation of all the budget deficits over time.
Most economists agree that budget deficits are a necessary evil because forcing a balanced budget would
not allow Congress to stimulate the economy.
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Additional Problems with Fiscal Policy2 Problems of Timing
• Recognition Lag- Congress must react to economic indicators before it’s too late
• Administrative Lag- Congress takes time to pass legislation
3. Politically Motivated Policies• Politicians may use economically inappropriate
policies to get reelected.
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Topic 11: Focus on National Debt
The National Debt: CNBC explains
• 1. What is the difference between deficit spending and the national debt?
• 2. What is the DEBT CEILING? • 3. If the government borrows $, how does it
get the money it needs? • 4. Who/what is the largest holder of U.S.
debt?
Where does the State and local government get $ from???
• Where does the Federal Government get its money???
Income taxes Tax based on the “income” a person earns
Americans pay an income tax to: 1. The federal government 2. The state government 3. The local government
These taxes appear on a person’s pay check stub
The purpose of filing taxes at the end of the year is to determineif a person has overpaid or underpaid their taxes
EXAMPLE OF PAYCHECK STUB
• Stossel goes to Washington: segment 1(7:40)
Countries with the highest income tax rates
Country Tax rate Kicks in at….
Aruba 58.9% $165,000
Sweden 56.6% $81,000
Denmark 55.4% $76,000
Netherlands 52% $72,000
Austria 50% $80,000
Belgium 50% $46,900
Japan 50% $217,000
United Kingdom 50% $231,000
Finland 49.2% $91,000
Ireland 48% $43,900
U.S. = 23rd; at 39.6% at $400,000 *Source: CNBC
• Where does the State and local government spend money???
Where does the federal government spend money ?
• everything else includes education, veterans benefits, national resources, foreign aid, Immigration, response to natural disasters
Military spending around the worldhttp://www.sipri.org/research/armaments/milex/factsheet2010
What is the national debt???
• Debt occurs when government revenue (primarily from taxes) is less than government spending.
• Therefore debt will rise whenever..– revenue falls– spending increases
Debt in the past decade
• 2001: $5.8 trillion• 2002: $6.2 trillion• 2003: $6.8 trillion• 2004: $7.4 trillion• 2005: $7.9 trillion• 2006: $8.5 trillion• 2007: $9.0 trillion• 2008: $10.0 trillion• 2009: $11.9 trillion• 2010: $13.6 trillion
• DEBT CLOCK
It would take 200,000 years to count to 1 trillion!!!!!
Countries with the largest debts
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Countries with largest debt as compared to GDPs
Ownership of the Debt
Congressional CommitteesAs a group, analyze the situation, identify the
problem, and identify your solution
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Unemployment Inflation GDP Growth
Good 6% or less 1%-4% 2.5%-5%
Worry 6.5%-8% 5%-8% 1%-2%
Bad 8.5 % or more 9% or more .5% or less
The Good, the Bad, and the Ugly
1.) 1933Situation:• GDP fell -1.2%• Inflation rate= -.5%• Unemployment Rate=25%
Your Solution:
What actually happened:• FDR increased public works via the New
Deal programs.
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2.) 1944Situation:• GDP grew 8%• Inflation rate= 3.7%• Unemployment Rate=1.2%
Your Solution: What actually happened: • War ended the next year and government
orders for war materials decreased.• Many public works programs were
discontinued116
3.) 1980Situation:• GDP fell -0.3%• Inflation rate= 13.5%• Unemployment Rate=7.1%
Your Solution:
What actually happened:• The next year, President Regan and congress
lowered taxes on individuals and corporations by about 30%. (Supply-side Economics)
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4.) 2003Situation:• GDP fell 0.5%• Inflation rate= 1.5%• Unemployment Rate=12.0%
Your Solution:
What actually happened:• Congress voted to give tax cuts to
citizens. (Bush Tax Cuts)
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